How Does Canadian Monetary Policy Influence the Value of the Canadian Dollar?
If you participate in Canada’s foreign exchange market or international trade, it is vital to know the factors affecting the loonie’s value, such as the Canadian monetary policy. So, how does the Bank of Canada’s monetary policy actions influence the exchange rate?
Understanding the Canadian monetary policy can help you determine the Canadian dollar’s purchasing power. And if you are an international trader, the monetary policy can help you understand the value of the Canadian dollar in the global markets.
This guide explores the role of Canada’s monetary policy in the foreign exchange market. You are about to find out how the Bank of Canada’s actions can influence the exchange rates through the Canadian Monetary Policy.
Let’s find out more!
The Objective and Effect of Monetary Policy on Exchange Rate
The primary objective of the Canadian monetary policy is to preserve the loonie’s value by keeping the inflation rate low, stable, and predictable. As a result, it helps Canadians make investment and spending decisions with a lot of confidence.
A stable inflation rate also encourages long-term investments in the Canadian economy. It also contributes to consistent job creation and improved productivity. Consequently, this has improved the Canadians’ living standards.
Here are the components of the Canadian monetary policy framework.
- Inflation-control target
- Flexible exchange rate
The framework makes monetary policy actions more understandable. It also helps the Bank of Canada demonstrate its responsibility to Canadians.
Now, let’s look at how the components of Canadian monetary policy works.
The primary role of the Canadian monetary policy is to maintain the inflation-control target, which is two percent. That’s the midpoint of the 1-3 percent target range.
So, who sets the inflation-control target?
The federal government and the Bank of Canada jointly set the inflation-control target and review it every five years. However, the Bank Governing Council monitors the monetary policy and maintains a stable price environment.
How the Bank of Canada Manages the Inflation-Control Target
The Bank of Canada, which is the monetary arm of the Canadian government, plays a significant role in controlling the country’s inflation.
Here are the different roles of the Bank of Canada as far as inflation is concerned.
Provides the Overnight Rate Target
The overnight rate, also called the key policy interest rate, is the interest rate provided by the Bank of Canada. It expects financial institutions to use the interest rate in financial markets for overnight (one-day) loans.
The key policy rate is the benchmark that all financial institutions like banks and credit unions use to determine the interest rates for their financial instruments. These include mortgages, consumer loans, and other types of lending.
Influences Short-Term Interest Rates
The Bank of Canada can raise or lower its key policy rate to attain the inflation target. So, if the inflation is above the target, the Bank will raise the policy rate. As a result, it encourages financial institutions to raise interest rates on all their loans and mortgages.
When financial institutions increase their interest rates, it will discourage spending and borrowing, easing the upward pressure on the prices of goods.
What about when inflation is below the target?
In that case, the Bank of Canada may lower the key policy rate. So, financial institutions will also reduce their interest rates on loans and mortgages, stimulating the economy. In other words, the Bank takes action when inflation rises or falls below the target.
Point to Remember
Canadian monetary policy adjustments often take time to work and bring their full effect on inflation. For that reason, the monetary policy rate setting depends on what the Bank believes inflation will be in the future, and not today.
When it comes to the exchange rates, the Bank of Canada rarely intervenes to support the value of the Canadian dollar. Instead, it lets the foreign exchange market sets how much the loonie is worth. That’s why Canada’s exchange rate is flexible.
The flexible exchange rate allows the Bank of Canada to implement an independent monetary policy best suited to Canada’s economic situation. Besides, it helps achieve the inflation target since the exchange rate movements help the economy absorb and adjust to internal and external shocks.
How the Floating Currency Works
The Canadian monetary policy does not affect the foreign exchange rates directly. It is because the Bank of Canada doesn’t intervene but instead lets the currency float. In other words, the loonie’s value rises and falls based on its demand and supply.
For example, suppose you’ve been travelling a lot from Canada to other countries. You have probably realized that sometimes you need more Canadian dollars to buy foreign currencies, and you need less some other times. That is what makes the loonie float.
The Bank of Canada doesn’t set the exchange rate for the Canadian dollar. Instead, it lets the market set its value. That allows the Bank to focus on adjusting interest rates to maintain the overall inflation in Canada at 2 percent.
Note that the demand for the Canadian dollar depends on the demand for Canadian products and services. Therefore, the dollar becomes more valuable when many people want to buy what Canada sells. Conversely, the value reduces when a few people buy Canadian goods and services.
The strength of Canada’s economy relative to other countries can also affect the dollar’s value. If the economy of a nearby country grows stronger than Canada’s, the Canadian dollar’s value will decrease. However, the loonie will become more valuable when Canada’s economy grows stronger than another country’s.
In a nutshell, here are some factors that can make the Canadian dollar go up or down.
- Canada’s interest rates relative to other countries
- Canada’s inflation rate compared to other countries
- Demand for Canada’s assets, such as bonds and stocks
Pros and Cons of Monetary Policy
Monetary policy has several advantages and disadvantages. However, we’ll only look at a few of them now that you know how monetary policy works.
Pros of Monetary policy
Here are the advantages of monetary policy.
- Can result in lower rates for mortgage payments
- Encourages the possibility of more investments as consumers spend more
- It helps to reduce inflation rates in a country
- Allows central banks to increase their monetary base and cash reserves in banks
- Promotes predictability and transparency
Cons of Monetary Policy
Like other financial instruments, monetary policy also has a few drawbacks that make it unfriendly. Here are some of the disadvantages.
- Monetary policy tools, like interest rates, are general and can affect the entire country’s economy.
- There’s a high risk of hyperinflation, especially when the interest rates are low. There could be overborrowing at cheap rates, causing a speculative bubble.
- Monetary policy can take a lot of time to get implemented
The relationship between exchange rate and monetary policy is not directly dependent, and that’s why the Canadian dollar is a floating currency. The Bank of Canada doesn’t use the monetary policy to set exchange rates but mainly focuses on ensuring low and stable inflation. Instead, it lets the market set the Canadian dollar’s value.